In the latest opinion issued in the Sun Capital litigation, the United States Court of Appeals for the First Circuit reversed the U.S. District Court for the District of Massachusetts judgment holding non-parallel private equity funds jointly and severally liable for a $4.5 million ERISA multiemployer plan withdrawal liability claim. While the court’s decision is certainly welcome news for private equity and other investors, the court’s decision to look beyond the form of entities chosen by the investors and determine whether a “partnership-in-fact” existed means that the First Circuit might have reached a different conclusion on different facts.

Important Legal Background

Businesses that are not sufficiently related do not share liability for each other’s ERISA obligations. “Trades or businesses” that are under 80 percent or more common control (and therefore part of the same ERISA “controlled group”) are sufficiently related and are jointly and severally liable under ERISA for certain pension and other obligations, including multiemployer pension plan withdrawal liability.

Facts of the Case and Summary of Earlier Litigation

In Sun Capital, two private equity funds, Sun Fund III[1] and Sun Fund IV indirectly[2] owned 30 percent and 70 percent respectively of Scott Brass, Inc. (“SBI”). The same two individuals, Sun Capital’s founders, controlled the general partners of Sun Funds III and IV. Approximately two years after Sun Capital purchased SBI, SBI filed for bankruptcy and the applicable pension fund assessed withdrawal liability against SBI and claimed that Sun Fund III and Sun Fund IV were jointly and severally liable under ERISA for SBI’s withdrawal liability.

In its first opinion, the District Court held that neither Sun Capital fund was a trade or business under ERISA and therefore there could be no “controlled group” liability.[3] On appeal, the U.S. Court of Appeals for the First Circuit disagreed and held that Sun Fund IV was a trade or business under an “investment plus” standard. The First Circuit remanded the case back to the District Court to determine whether Sun Fund III was a trade or business under the investment plus standard and, if so, whether Sun Fund III and Sun Fund IV were under common control with SBI. [4]

On remand, the District Court found that Sun Fund III was a trade or businesses under the First Circuit’s “investment plus” standard largely based on the same factors used by the First Circuit to reach its conclusion for Sun Fund IV and also because the offset to management fees paid or payable by Sun Fund III to its general partner pursuant to its limited partnership agreement[5] provided a valuable benefit that would not be available to an ordinary investor.

Because neither Fund owned 80 percent of SBI, however, the District Court noted that “in the absence of such mechanism by which the ownership interests of Sun Funds III and IV would be aggregated, withdrawal liability would not extend to the Plaintiff Funds themselves under these rules.” The court seemed concerned that following the applicable PBGC and IRS regulations without more would require a holding that the funds were not in common control with SBI. To address this concern, the court accepted the pension fund’s argument that Sun Funds III and IV had created a “partnership-in-fact” that sat above Scott Brass, LLC, a limited liability holding company owned indirectly by Sun Funds III and IV through this partnership-in-fact, and this partnership caused Suns Fund III and IV to be in common control with SBI.[6]

The Decision

While Sun Fund III and Sun Fund IV were clearly organized as limited partnerships and Scott Brass LLC was clearly organized as a limited liability company, the First Circuit stated ERISA and the tax law require courts to look beyond the parties’ labels to the substance of the relationships and analyzed whether the District Court had correctly concluded that Sun Funds III and IV had established a partnership-in-fact above the LLC. The court then analyzed the following eight factors adopted by the US Tax Court in Luna v. Commissioner to determine whether a partnership existed:

  1. [t]he agreement of the parties and their conduct in executing its terms;
  2. the contributions, if any, which each party has made to the venture;
  3. the parties’ control over income and capital and the rights of each to make withdrawals;
  4. whether each party was a principal and coproprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income;
  5. whether the business was conducted in the joint names of the parties;
  6. whether the parties filed Federal partnership returns or otherwise represented to [the IRS] or to persons with whom they dealt that they were joint venturers;
  7. whether separate books or accounts were maintained for the venture; and
  8. whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise.[7]

The Court found the eighth factor favored a partnership-in-fact finding because Sun Funds III and IV sought out potential portfolio companies together and indirectly jointly developed structuring and operating plans for target companies. In addition, the two founders of Sun Capital controlled the general partner of each Fund and “essentially ran things for both the Funds and SBI.” On the other hand, the Court found many of the other Luna factors counseled against a partnership-in-fact finding. First, Sun Funds III and IV did not intend to join together in the present conduct of an enterprise (other than their coordination within Scott Brass, LLC). The Funds had disclaimed any partnership between the Funds; most of the 230 limited partners in Sun Fund IV were not also limited partners in Sun Fund III. In addition, the Funds filed separate tax returns, kept separate books, and maintained separate bank accounts. Moreover, the Funds did not invest in parallel, demonstrating some independence in activity and structure. The creation of an LLC by the Funds to acquire SBI also evidenced an intent not to form a partnership as it prevented the Funds from conducting business in their joint names and limited the manner in which they could exercise mutual control over and assume responsibilities for managing SBI.

The First Circuit found other court opinions finding a partnership-in-fact in the common control context were distinguishable in that those cases involved individuals rather than limited liability companies.

The court stated that “[t]wo of ERISA and the MPPAA’s principal aims—to ensure the viability of existing pension funds and to encourage the private sector to invest in, or assume control of, struggling companies with pension plans—are in considerable tension.” The court indicated it was reluctant to impose withdrawal liability on Sun Fund III and IV because of a lack of a firm indication of congressional intent to do so and any further formal guidance from the PBGC. Consequently, the court reversed the judgment of the District Court and remanded the case with instructions for the District Court to enter judgment in favor of Sun Fund III and IV.